It is a general tenet that competition serves customers well, enabling them to acquire better products at lower prices. Of course, this premise underlies the antitrust laws. In the aerospace and defense industry, the customers are often government agencies that are monopsonists with significant purchasing leverage. Government customers often have contracting mechanisms that are not generally available in the commercial marketplace, such as the ability to receive certified cost and pricing data from contractors. From time to time, contractors have attempted to rely on arguments that the government’s buyer power and contracting rights ensure that contractors cannot impose unreasonable pricing on the government, even if there is no or limited competition. The antitrust regulators and the U.S. Department of Defense (DoD) have long rejected that notion, stressing that regulation is not a substitute for competition. A recent DoD study supports that general proposition, and provides data the DoD interprets as showing that the presence of competition improves contracting outcomes for the government. See DoD 2014 Annual Report on the Performance of the Defense Acquisition System. This report provides some interesting thoughts and data that may impact future antitrust agency reviews.
The DoD’s desire for competition is clear. “Competition—or at least creating competitive environments—is a central tenet of our Better Buying Power initiatives. Competition is the single best way to motivate contractors to provide the best value (i.e., the best performance at the lowest price).” 2014 Annual Report at p. 17. DoD’s analysis of 83 contracts found that, where contracts were competed, contractors’ average margin was 5.5 percent, compared to 7.7 percent for sole-source contracts. Also, when contracts were competed, they had lower observed price growth (11 percent compared to 48 percent) and lower observed schedule growth (0.07 years compared to 1.66 years) than contracts that were awarded sole source. 2014 Annual Report at p. 98. Interestingly, DoD’s data show that even in the case of sole-source modifications to contracts that were initially awarded competitively, price growth and schedule growth were far lower compared to contracts that were awarded sole source at the outset. 2014 Annual Report p. 98.
DoD offered some potential explanations for the observed data.
This data cannot tell us why cost and price growth are lower on competed contracts. We might have expected competitors to bid below their cost estimates with the expectation of making up any losses in engineering cost changes, but that that does not appear to be happening systematically. It might be that competition is driving bidders to conduct more careful cost analysis and thus more realistic bids. It might also be that contractors put their best people on competitive efforts and thus have better performance. Further analysis is needed.
2014 Annual Report p. 97. DoD concluded that in light of the data, it must continue to strive for competition wherever possible, noting:
Competition is effective—when viable. Competed contracts perform better on cost, price, and schedule growth than new sole-source or one-bidder contracts in development. (i.e., a contractor’s knowledge that a competitor is not available may affect bidding and subsequent performance relative to that bid.) Thus, we must continue our efforts to seek competitive environments in creative ways. Unfortunately, direct competition on some [Major Defense Acquisition Program] contracts is often not viable—especially in production, where significant entry costs, technical data rights, or infrastructure may be barriers. In response, we are seeking ways in which competitive environments and open-system architectures will allow us to introduce competitive pressures.
2014 Annual Report p. 102.
Implications of the DoD Report
Of course, the DoD and the military services control the nature of the procurements they use to acquire products and services, and they will determine whether their acquisition programs will change in some fashion as a result of the reported findings. The concepts noted in the report, however, do provide some insights that may come up in the antitrust reviews of aerospace and defense mergers, investigations and teaming agreements.
Contractors may argue two competitors are enough to ensure competition. The DoD report does not evaluate the impacts of the closeness of the competitive offerings of the firms that it identified as competitors, nor does it analyze how many competitors the winning bidder faced, other than identifying a procurement as having been “competed,” implying there was more than one bidder. The findings of the report may provide some ammunition to contractors defending a combination that will result in only two bidders remaining for a contract. The report indicates that the mere fact of competition results in competitive outcomes, or at least competitive benefits. The antitrust regulators evaluating a bidding market will typically evaluate how the different potential bidders likely rank in terms of cost and technology. They assume that a combination of the top two bidders would result in a decrease in competition because the competitive constraint had been the second-place firm, but after the merger that constraint would come from the third-place firm. That analysis assumes, at some level, that the best-placed firm knows how the other firms will bid, so that the best-placed firm can compete less aggressively with the knowledge that the second-best competitor has a less desirable product offering, including price and technology. Those assumptions may not hold, especially in times of declining defense spending and limited contracting opportunities. Put more directly, is the best-positioned firm likely to pull its punches and compete less aggressively when its opponent is somewhat less formidable, or will it throw haymakers to be sure it wins, especially since the implications of loss can be so extreme? The report offers facts to support that competition results in more competitive outcomes for the customer, and is silent on whether competition from a closer rival results in a more competitive outcome than competition from a more distant rival.
Contractors should understand the implications of the report on arguments that the government’s buying power will prevent any anticompetitive impacts from a transaction. As noted, the antitrust enforcers have been clear that government procurement mechanisms cannot protect the customer as well as competition will. The report provides some data from the customer itself supporting that proposition.
Contractors should not assume “franchises” will remain theirs forever, which has implications for business planning and for antitrust analysis. The DoD indicates that it wants to increase the proportion of its purchases that are made through competitive procurements. It has also indicated that it will try to find ways to keep systems open, so that firms that do not win the initial design contract still can compete for awards during the life of the program. This obviously has implications for contractors’ forecasts and pipelines to the extent programs can be recompeted. If this dynamic plays out, then one of the traditional antitrust defenses—that the procurement and selection has already occurred so the merger cannot impact competition—may become less secure. If the government is going to take steps to try to maintain competition for future purchases of a system beyond the initial contract, then the regulators may put more focus than they historically have on possible competition between the merging companies for those potential future procurements. Also, to the extent companies team for a procurement, they may need to focus even more on the time frame covered under that teaming agreement and whether and how the current teammates will team or compete on potential future procurements.
The DoD report provides an interesting read, and has implications for antitrust analysis applied to mergers, acquisitions and teaming agreements.
The McDermott Difference
McDermott Will & Emery has a dedicated Aerospace & Defense Group composed of skilled lawyers across the Firm’s practices with demonstrated success advising clients active in this specialized industry. This newsletter is part of a series designed by McDermott to address issues affecting the industry; stay tuned for future publications. To learn more, please contact your regular McDermott lawyer or an author.